Short Sale of Rental Property

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Short Sale of Rental Property

Meg Hoff
Omaha, NE · Member since 2012 · 2 posts · 0 votes

I am considering a "strategic default" of my condo property in California. I bought it as my primary residence in 2004, but have rented it out for the past two years. I am more than $100K underwater, and do not qualify for refinance, loan mod, HARP, etc. I am wondering about the tax consequences, since it's considered an investment property, will it be treated as a loss? I can't use the Mortgage Debt Relief since it's not my primary residence. I am going to try and short sell it in the next few months.

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Jon Holdman
Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
13y

Either a short sale or a foreclose may result in taxes on the "phantom income" produced by the forgiven debt. I believe California is a non-recourse state, so they can't come after you for the shortage. But expect to see a 1099 for the forgiven debt.

If you do short sell it at a loss, that would produce a capital loss. That may be usable to offset other capital gains, but the amount is limited each year.

I'd strongly advise a conversation with your CPA to be sure you understand exactly what may happen.

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  • Jon Holdman
    Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    13y

    Either a short sale or a foreclose may result in taxes on the "phantom income" produced by the forgiven debt. I believe California is a non-recourse state, so they can't come after you for the shortage. But expect to see a 1099 for the forgiven debt.

    If you do short sell it at a loss, that would produce a capital loss. That may be usable to offset other capital gains, but the amount is limited each year.

    I'd strongly advise a conversation with your CPA to be sure you understand exactly what may happen.

    2Reply
  • Tiger M.
    property manager · Las Vegas, NV · Member since 2012 · 502 posts · 171 votes
    13y

    I agree with Jon Holdman seek legal advise. You may consider moving back in for a short time through the process to reclaim the Owner occ. status for the IRS. The federal fiscal cliff debate outcome could change your course so watch closely.

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  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    13y

    Meg, I am Not a CPA........however, if you are "insolvent" as per IRS Form 982, you'll avoid the taxes. Essentially, if you're net worth-not considering the shorted property/mtg- is negative, you're exempt. If not negative, you're liable for taxes on the amount of income that equals the amount your net worth is positive. (ie. $120,000 forgiven debt....$30,000 positive net worth outside of short transaction.......equals liability for income tax on $30,000). This is the basics, talk to a CPA.

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  • Monica Breckenridge
    Rental Property Investor · Colorado Springs, CO · Member since 2010 · 476 posts · 305 votes
    13y

    I knew an investor that did that and he regrets it. Now he has to pay about $30,000 in taxes. A tax professional should be able to look at your situation and tell you what you may end up paying in taxes.

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  • Scott Graves
    Milwaukee, WI · Member since 2012 · 26 posts · 1 vote
    13y

    Does the debt relief act only include primary residence?

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  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    13y

    Yes, MDRA only applies to primary residence and for purchase or improvement financing, not any funds pulled out.

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  • Sandy Blanton
    Residential Real Estate Broker · Pensacola, FL · Member since 2012 · 221 posts · 49 votes
    13y

    I've done hundreds of short sales for people in all kinds of situations. 100% of the sellers were glad they were able to do the short sale. As Jon mentioned, sell at a loss, the capital loss should offset the debt forgiveness. The person that mentioned the insolvency issue is right on. Consult a CPA, but 99% chance you should do it.

    Hire an experienced CDPE Realtor. Do yourself a favor and do not list with a non-CDPE. IMO:)

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  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    13y

    Meg Hoff,

    You definitely need to sit down with someone and discuss the situation. There are certain other exceptions.

    Wayne Brooks, It definitely includes the value of that property. As they look at insolvency immediately before the cancellation.

    Monica Breckenridge,

    I can bet he definitely wasn't insolvent then or the accountant didn't know any better. If it was property he had refinanced several times then I'm sure he has such a low basis that it was definitely taxable.

    Scott Graves,

    Yes it it only refers to principal residence debt.

    [email protected]224-381-2660
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  • Sandy Blanton
    Residential Real Estate Broker · Pensacola, FL · Member since 2012 · 221 posts · 49 votes
    13y

    Meg Hoff Steven Hamilton II Steven, if someone gets a $100K debt forgiveness (ie income of $100K), the worst case scenario is they pay income tax on the $100K, perhaps $35K? They're still $65K ahead.

    Can you think of any reason this isn't beneficial, if just looking at the numbers? I can't. IMO:) What say you?:)

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  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    13y

    Sandy Blanton,

    That is precisely correct. I would much rather only owe some tax than have to pay a lot more.

    The ideal way to handle the transaction is to add the cancelled debt to the sale price. This should offset fairly evenly overall.

    -Steven

    [email protected]224-381-2660
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  • Sandy Blanton
    Residential Real Estate Broker · Pensacola, FL · Member since 2012 · 221 posts · 49 votes
    13y

    Good idea in theory, but impossible to do on a HUD. Sales price has to appraise/never will since it would reflect the old value of the property. Host of challenges, not possible. Unfortunately.

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  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    13y

    Sandy Blanton,

    I am referring to how it should be reported on the tax return.

    -Steven

    [email protected]224-381-2660
    1Reply
  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    13y

    @Steven Hamilton II,

    You're right. What I was trying to say was, excluding the Negative Equity of that property/transaction, the simple test is if your net worth is negative the tax would be avoided.

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  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    13y

    Yes Wayne Brooks,

    It is if it is negative by the debt cancelled or more. You can exclude up to the amount your net worth is negative.

    -Steven

    [email protected]224-381-2660
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  • Meg Hoff
    OP
    Omaha, NE · Member since 2012 · 2 posts · 0 votes
    13y

    Thanks for everyone's input. I did speak with a CPA familiar with short sales who was able to help clarify my particular situation. The Mortgage Debt Relief Act does not apply to rental property, since it is considered an investment by the IRS. I will use a gain/loss calculation to determine if I have a capital gain or a non-deductible loss. In my case, since my adjusted basis (purchase price minus deprecation) is greater than the total amount of my non-recourse debt, I have a non-deductible loss and should not owe any cancelation of debt income, and also should not have to declare insolvency. This was a relief to hear!

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  • Robert AdamsBusiness Member
    Real Estate Broker · Henderson, NV · Member since 2009 · 1k+ posts · 373 votes
    13y

    Great advice in this thread. Make sure you discuss the specifics with your CPA and attorney prior to making your final decision as you want to make sure you did not leave out any important details in this post.

    [email protected]702-349-9175
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  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    13y

    @steve Hamilton (mention doesn't work on the IPad). On a rental property, the loss from the actual sale price would be a capital gain loss, correct? The income triggered from the forgiven debt would be ordinary income, right? Does the capital gain loss off set the ordinary income, or aren't there yearly caps for the capital loss?

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  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    13y

    Wayne Brooks,

    It is a bit different for a rental property you are not subject to the capital loss limit in the year of the sale for that transaction only.

    The proper way to show it is:

    Sales price + the canceled debt - adjusted basis = gain/loss

    -Steven

    [email protected]224-381-2660
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  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    13y

    Steven Hamilton II just like how you look at the insolvency test, I'm always looking for the simple formula, to remember and to share.

    So essentially, sales price plus forgiven debt is the same as current loan balance.
    So, current loan balance minus basis equals gain/loss for a short sale, non OO, assuming the insolvency test doesn't help?
    Thanks.

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  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    13y

    Wayne Brooks,

    That is the short of it. Also, in some cases the qualified real property business indebtedness section may be of assistance.

    -Steven

    [email protected]224-381-2660
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  • Kris Lai
    Investor · Daly City, CA · Member since 2013 · 29 posts · 4 votes
    13y

    Hi Steven.. I'm a newbie here and stumbled upon this thread trying to find answers to my similar situation. Wondering if you could add a few tips for me:

    I'm in escrow to short sell my rental property. I purchased it in 2004 for $391k, currently owe approx $359k (303k on 1st, 56k on HELOC), sale price is $160k. I was hoping to claim insolvency but just realized my 401k and IRA balances count towards assets so it doesn't look like I'd qualify (correct me if I'm wrong).

    So basically if I understand your math correctly, I would be on the hook for taxes based on $39k: ($160k sale price + $199k forgiven debt) minus $320k adjusted basis ($400k purchase price/improvements - $80k depreciation since 2004). Would this be correct?

    Here's an additional kicker: the house has been vacant since March 2012; it's not safe to live there, and I'm not delinquent. My accountant seems to think I cannot claim it as a business since I wasn't "actively" seeking renters. How does play into my tax situation? Thanks!

    0Reply
  • Kris Lai
    Investor · Daly City, CA · Member since 2013 · 29 posts · 4 votes
    13y

    btw, the house is in CA. thanks!

    0Reply
  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    13y
    Originally posted by Kris Lai:
    Hi Steven.. I'm a newbie here and stumbled upon this thread trying to find answers to my similar situation. Wondering if you could add a few tips for me:
    I'm in escrow to short sell my rental property. I purchased it in 2004 for $391k, currently owe approx $359k (303k on 1st, 56k on HELOC), sale price is $160k. I was hoping to claim insolvency but just realized my 401k and IRA balances count towards assets so it doesn't look like I'd qualify (correct me if I'm wrong).

    So basically if I understand your math correctly, I would be on the hook for taxes based on $39k: ($160k sale price + $199k forgiven debt) minus $320k adjusted basis ($400k purchase price/improvements - $80k depreciation since 2004). Would this be correct?

    Here's an additional kicker: the house has been vacant since March 2012; it's not safe to live there, and I'm not delinquent. My accountant seems to think I cannot claim it as a business since I wasn't "actively" seeking renters. How does play into my tax situation? Thanks!

    @Kris Lai ,

    That is correct, those retirement account balances will count.

    Is the property held in an LLC? Was it a residence previously? If so, why did you convert it to rental property? How long as it listed for sale? Why was it vacant? Why did you not repair it? Was it cash flowing?

    I calculate a taxable income of 39k of depreciation recapture. I did not check your depreciation. I do not see a problem with treating it as sold business property provided it had been a rental for a long time.

    [email protected]224-381-2660
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